Pass-through Entity Stumbling Points
Creation of a U.S. pass-thru business entity (partnership or S-Corporation) assumes business income to get taxed on the owners’ individual tax returns keeping the entity free of tax.
Generally, this is correct. However, the IRS and state tax authorities have a multitude of opportunities to levy penalties for not meeting certain not-so-obvious business deadlines.
Modest base penalty amounts rise steeply when multiplied by the number of months of delay, then by the number of shareholders.
Analysis of Best Coffee, LLC (Sample Firm) From New York
Let’s look at the stumbling points of Best Coffee, LLC. The company was established by two friends from Brooklyn, New York and is treated as a partnership. The partners worked in the shop themselves. They hired three independent contractors for website creation, marketing campaign and equipment installation. Gross business income for the year was $200K. The net income was $100K.
First opportunity for penalties: January 31
The first opportunity to receive penalties occurred on January 31. It was the due date for filing the forms 1099-NEC with the IRS to report payments made to the independent contractors.
One day of late submission of three forms 1099-NEC would cost the business owners $150 ($50 x 3). Luckily, the partners filed the payroll forms on time.
Second opportunity for penalties: March 15
The next critical date was March 15th, the third month after the end of the business accounting period.
By that date, they had to either file a federal return for the partnership or submit an extension.
Filing the partnership return to the IRS on March 16 without an extension would trigger penalties of $410 ($205 x 2) — a fixed amount for the partial month of delay multiplied by the number of partners.
Assuming Best Coffee, LLC timely filed the payroll forms and submitted a federal extension for the federal return — can they now exhale and patiently wait for the accountant to complete their partnership return? Unfortunately, no.
Numerous state filing obligations
When the partners established Best Coffee, LLC they followed the advice of a fellow business owner and had their LLC registered in Nevada. Assuming this will save them the hassle of dealing with the New York State filing maze. They timely filed the NE business report and paid the annual fee of $125 on the prescribed date. Alas, that was just the start of the state filing journey.
Despite being incorporated outside of New York state, they have a full range of filing obligations in New York State and New York City where the business has permanent establishment and generates revenue.
The partnership had properly filed New York State quarterly sales reports through the year. However, the partners did not request a New York State partnership extension and did not file the New York City UBT (Unincorporated Business) Return — both due by March 15.
The federal, state and UBT returns for the partnership were filed on August 1. The penalty for the late filing of NY state return without the extension was $500 ($50 x 2 x 5) — a fixed amount for each full or partial month of delay multiplied by the number of partners.
Based on the net income of $100K, the partners were supposed to pay $4,000 New York City UBT tax (4% of net business income). Failure to pay the tax by March 15 will cost them $1,000 (5% for each month of payment delay after the prescribed due date, up to 25% of the total amount due). Note — these figures do not include interest.
Finally, they also missed paying the $50 New York State franchise tax based on their gross income of $200K.
What if Best Coffee, LLC was owned & operated in California, North Carolina, or Kansas? Would the state filing obligations be simpler and annual fees lower? The amount of state fees and penalties vary by state but the general scope of filing obligations is similar in all U.S. states.
How to avoid missteps
- Remember that the business that you operate has filing obligations in the state of incorporation AND in the state (or multiple states) where income is produced.
- If you own a US trust, there may also be state filing obligations in addition to the IRS filing obligations.
- The non-personal state filing obligations apply as well to so-called “tax-free states”, such as Florida, Texas, or Tennessee.
- When requesting a non-personal extension, indicate both the state of incorporation and the U.S. state or states where income is produced.
- When you see the confirmation of the federal extension complete, yet do not see the state extension confirmation - inquire with your tax preparer if the federal extension covers the state or if you need to mail a state extension with payment separately.
- If the U.S. state/municipality requires an annual franchise fee - mail the annual payment to the state before the state return filing due date.
- The best way not to miss the state annual fee is to make an advance estimated payment calculated on your prior year’s state business return.